Buy Bank stocks that dilute large expensive equity!

One of the allergies that fundamental investors have is their reluctance to buy companies that dilute equity on a consistent basis. Before I started understanding the banking sector I had the same strategy of buying companies that value their equity and do not dilute it very fast. Though I do not consider equity dilution a sin banking is a sector where equity dilution could actually work out in the investor’s favor if such a dilution is being conducted subject to the following factors:

1)      The bank should already be doing a RoE of more then 20%. That means that the shareholders equity is being optimally utilized. Banks that dilute equity with a RoE of less then 20% are on the wrong track. Instead of issuing fresh capital they should instead improve efficiency and raise the RoE.

2)      The second aspect to look here is for the Banks to issue equity at a price which is significantly higher then book value. A Bank that issues capital at 3 times book is worse off then bank that raises capital at 6 times book. More on that later in the illustrative examples.

3)      The equity dilution has to be substantial compared to the present net worth. For example a Bank raising capital equal to just 100% of its net worth would do better in contrast to a Bank raising capital for 10% of its net worth. In point number (3) adherence has to be kept that the RoE is not dilutive (1)

4)      Diluting equity through QIP/FII placements/MF placements is not as good as selling it to a one time private equity investor. That is because MF’s create a supply overhang the moment price goes up unlike the serious long term investor who would rather wait for a longer period of time.

Now let us consider two situations:

Conclusion:

ü      The appreciation in price in both the cases was pronounced but in the case of the costly bank price appreciated by a whopping 150%

ü      If the banks are valued at pre dilution PE the prices would become far more aggressive.

ü      In the Yes Bank conference call the management told me that it takes about 18 months to hit the pre dilution RoE. I take that time period to be the sector yardstick.

ü      Unlike a manufacturing company banks can deploy the money raised right from day 1 and it would form apart of their core operating income. Since in the case of banks income from lending is the core income.

ü       Manufacturing companies take time to deploy the money and till such time the income from investments is classified as non core or other income,

ü      For repetition the points to be noted are

a)      High price/book

b)      Substantial dilution in relation to net worth

c)      High RoE

I am not too sure if all of you would have understood this but just try and read the table again and the matrix should fall into place. When I started looking for bank stocks about a month and a half back the first thing that I was looking for was for good banks that have effected a major dilution on the basis of the criteria set out in the points above.

Accordingly I present the case of two of India’s best private sector banks that have diluted equity earlier this year as per the conditions set out above:

So catch the next bank stock that dilute expensive equity.

Diwali Dhamakaaaa

Excellent researched analysis.